Navigating Entity Selection for Small Businesses

Expert guest Jeff Darley joins Roger and Annie to discuss how to choose the right business entity for small business owners. They cover LLCs vs S-Corps, reasonable salary, payroll taxes, and more.

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• (00:00) - Federal Tax Updates Episode 18
• (02:17) - Background on Jeff Darley
• (15:03) - Payroll Taxes and Social Security
• (19:59) - S Corp vs C Corp
• (25:40) - Dealing with IRS on Reasonable Salary Audits
• (32:34) - Process of Electing S Corp Status
• (39:43) - Estimated Tax Payments
• (43:37) - Selling a Business - S Corp vs C Corp

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Annie Schwab

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Website : https://littleton.padgettadvisors.com/our-team.php
LinkedIn : https://www.linkedin.com/in/jeff-darley-77839b2
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All content from this podcast by SmallBizPros, Inc. DBA PADGETT BUSINESS SERVICES is intended for informational purposes only.

Creators & Guests

Host

Annie Schwab, CPA

Franchisee Operations Manager at Padgett Business Services

Host

Roger Harris, EA

President at Padgett Business Services

Guest

Jeff Darley

Owner, Padgett Business Services

What is Federal Tax Updates?

CPAs, Enrolled Agents, and Tax Preparers can keep up-to-date with the latest federal tax information while earning NASBA approved CPE credits and IRS approved CE credits by listening to the bi-weekly Federal Tax Updates podcast. The hosts Roger Harris and Annie Schwab have over 75 years of tax experience between them, which has been featured in various media outlets including Wall Street Journal, USA Today, The Morning Business Report, Bloomberg Business News, and Accounting Today.

Warning: This is a machine-generated transcript. As such, there may be spelling, grammar, and accuracy errors throughout. Thank you for your understanding!

Roger: Hello again everybody. This is Roger Harris with the Federal Tax Updates podcast. And I'm joined as always by Andy Schwab. Andy, how are you doing today.

Annie: Good morning. I'm doing pretty good. How about you?

Roger: I'm great I'm great. We're going to do something a little different. You've probably gotten sick of hearing just me and Andy talk for all these podcasts, so we thought it [00:00:30] would be a good idea to, since you guys are out there in the real world and dealing with these issues day to day, that we bring in one of our padget office owners and, and kind of let him share his perspective about our topics. And actually we kind of let him pick the topic. So, Andy, why don't you introduce our guest?

Annie: I'll be happy to. Today joining us is Jeff Darley. He actually joined Padget back in 22,000. Actually his family, his parents had a had a firm previously [00:01:00] before he did. But he's been with us for a while. He's out of Littleton, Colorado, and he's going to join us today to talk about entity selection. So Jeff, welcome. Thank you so much for volunteering to speak with us.

Jeff: Thanks for having me.

Roger: Yeah. Thanks, Joe. Yeah, we yeah, we thought, you know, hearing from somebody in the real world. And Jeff, before we get into the details and he talked a little bit, talk a little bit about your background, how you got into Padget. And then we'll talk about, you know, the issue that you raised that you thought was [00:01:30] relevant to our audience. So talk a little bit. Tell everybody who you are and give me a little of your background.

Jeff: Well, I'm a Colorado boy through and through. My parents are from here. My grandparents were from here and I went to CSU. And when I graduated, I went into the corporate world that a lot of accountants do, and I really didn't care for that at all. It was just not my personality. Not your thing to be in the corporate world. So I after about a year, I went to a small 30 person company and was their CFO and they sold truck tires like to [00:02:00] farmers and to off the road truckers on the road, truckers, stuff like that. And it was a great learning experience for me. I learned how to sell. I learned how to talk to people, listen to it, because all it was was just a bunch of guys on the phone trying to sell tires to truckers, right. And so it was a great education. The owner was a little bit of a nut. So when my father had a pageant for about two years, he said, you know, this is a pretty good deal. You ought to come check this out and you can. He says, I don't want to grow it anymore. I'm just going to retire in a couple of years. But if you want to come on board and do [00:02:30] what you want with it, please do. And it was 23 years ago. He retired, I don't know, 16 years ago, I think, and I've just loved it. It was the greatest decision of my life. I've loved the partnership with pageant, but mostly I love helping small business owners get through this maze, right. That's what I love about this job the most.

Roger: Yeah. You know, that's a good description. I heard your story. I actually started very similar. I actually worked in a tar tire sales place myself, and that's where I learned to sell tires to people. So that's not a prerequisite to join pageant, by the way, that you had to work [00:03:00] in tire business before.

Jeff: It does help with the sales. Yeah.

Roger: You know, if you can sell somebody a set of tires, you can probably sell them something they really might need, like accounting and tax.

Jeff: Yeah. If you've ever talked to a trucker from, you know, a different state from you and, you know, convince them over the phone to buy 16 tires from you, you're doing doing something right. That's a tough.

Roger: Sell. Yeah it is. Yeah. But we're thankful that Jeff's here. Now. What? We wanted Jeff. And we're going to bring in some other guests as we go forward. We [00:03:30] ask him, what is something that you consistently discuss with your small business clients, you know, and what's a topic that you think would be of interest to to our audience? And Jeff, why don't you explain kind of what you came up with and then we'll, we'll we'll start digging into it. But what do you talk to your clients, your small business clients about on a regular basis?

Jeff: Well, the very first question new clients come in with is, should I be an LLC or should I be an S corporation? You know, attorneys [00:04:00] love the LLC. That's what they always say. Everyone should be for the liability protections. And I have no reason to disagree with that. But at a certain level, we have to start looking at an S corporation as a business grows, becomes more profitable. And I think that's by far and away. And then how to appropriately use the S corporation for the most tax savings and the and protections from the IRS and auditing protections and things like that. So it's by far and away the first question. Almost every single client asks me, am I doing [00:04:30] this right. Mm.

Annie: It's an important question. It is. And it depends on their goals and where they are in the stage of the business and revenue and employees and where they're located. I mean, all of those things come into play. So it seems like a very simple question, but I'm guessing it's not always a simple answer.

Jeff: Well, it isn't because like you said, do they have employees or not? That's a that's the first consideration when you're looking at should they be an S corporation or not? Because in my opinion, one of the largest [00:05:00] stumbling blocks or the most expensive things is payroll. Adding payroll if you're the only owner, like if it's just you and you have no employees, that can be expensive. It can be $1,000 to thousand hundred dollars a year just to add yourself as an employee. So if you already have employees, that's one less barrier you have to overcome to becoming an S corporation. It's cheaper basically, because you're already incurring the payroll expense. So that's a that's a big consideration. But I think the largest consideration when deciding when to switch [00:05:30] to an S corporation is the profitability of the company. That's by far and away the most important consideration. I like to tell my clients that somewhere around 40 or $50,000 in profitability is a good time to start looking at it. The reason I picked that number is because of the cost, basically. So if you're an individual, if your client's an individual and they have no employees, you have to add the cost of the payroll. Then you have to add the cost difference of going from a schedule C to an S corporation. So [00:06:00] a schedule C might add 300 to $400, maybe even to $500 to the cost of a tax return. Whereas doing an S corporation can be 1000 to $2000, typically for a fairly easy S corporation tax return, depending on the part of the country you're in. And and if you can find an accountant to even do it for that much, some of them are even higher than that. So you have to look and then you have to pay state unemployment on yourself, federal unemployment on yourself. And those are relatively small costs. But it all adds up when you're talking about a $50,000 [00:06:30] profitability. Yeah.

Annie: Yeah, I.

Roger: Think I know the answer to this. Do you find when they come to you, after having talked to their attorney, that the attorney has had any of these discussions with them, or has it just basically been you need to be an LLC or you need to be an S Corp and good luck.

Jeff: They rarely say that they that they should be an S corporation. It's always they always fall back on LLC. They don't get into tax considerations at all, which isn't their really their job. That's why they need to contact us.

Roger: It's almost better if they don't get into [00:07:00] something because unless they're unique, they don't know all the rules. They just. But sometimes they think they do.

Annie: That's the and you made a good point. You made a good point about payroll because if you're not running payroll that's new deadlines, that's new calculations, that's new tasks that are placed on the the owner's plate. So it is not only the cost, but it's the training and getting getting familiar with the process and filing those.

Jeff: It's complicated. And if you if you try to do [00:07:30] payroll through like QuickBooks online or something like that on your own, now you've got all these reports that are due every quarter and payments. And when do they do and how, you know, how much do I pay? Am I doing this right? Am I filling these out right? It's complicated. So you almost have to hire an accounting firm or a payroll firm to help you, in my opinion. And that's where the costs come in. And so I'm just doing a simple cost benefit analysis when I'm talking to people about whether they should be an S corporation or not.

Roger: When you talk to these people, because once you form any kind of entity, [00:08:00] there's more structure all of a sudden around your business and a lot of small business owners, Jeff, as we all know, just want to do what they do sell tires. They don't want to. They don't want to worry about structure. They don't worry about details. They don't want to worry about all the things. How do you help them understand that once you choose an entity type, that there is some structure, there are some rules. And how do you, as a small business owner, need to change the way that [00:08:30] you've typically done things? What are some big problems or areas that you see that you have to address?

Jeff: Well, like you said, if you just have a single person tire sales, well, let's take an electrician. Just a guy that was being was an electrician for another company forever decided he could make more money doing it himself. So he goes out on his own and he's making $100,000 a year in profit. You know, we've done everything we can to reduce the profit, and that's what we've ended up. Well, he's been running this as his simple checkbook. All the money goes [00:09:00] into his personal account. He pays his business bills out of that. He pays his personal bills out of that. He has one credit card that he does both with, and then he just tries to cobble together a profit loss statement at the end of the year to get his schedule C done. So I always recommend people have a separate bank account and a separate credit card or debit card for their business, regardless of how they're structured. But it's very important when you become an S corporation for again, we're not attorneys, but to advise our clients that they should be separated and that they need to do this simply for liability [00:09:30] protections as well as. Very important and audit protections. You know, the IRS is going to do the same thing we do when we're helping our clients put a PNL together. They're going to lay out 12 bank statements and add up the deposits. And if your deposits don't equal your sales, why don't they? And you know, these are the simple kinds of things you can do just by having a separate bank account in your business name registered with an Ein number registered on the Secretary of State. Banks require those two items to open up a business bank account. And I think that that's a wise thing to do regardless, but especially if you're an s-corporation. [00:10:00]

Annie: The recordkeeping, you just.

Jeff: Have to train them up a little bit.

Roger: Yeah. Because if you're doing this and part of the reason they do this is for, like you mentioned it, liability protection. But you can actually pull some of that back or make it easier for people to pierce that veil if you don't act like a corporation. To your point, Jeff, if if you co-mingle your funds, how do you say that your business and you are separate if someone wants to take you to court. So it's not just for tax reasons, it's it's also to help protect [00:10:30] that. Right. Reason that you started this journey was in many instances for liability protection. And yet sometimes you do things just because it's the way you always did it, and you get rid of that protection.

Annie: And that goes for credit cards. Or if you buy a vehicle, it needs to be titled in the company name. If you, you know, your credit card, your bank accounts, any, any business transactions going back and forth should always be with the business name and then the customer. So [00:11:00] try to keep it, you know, loans, all of that stuff separate.

Jeff: And they're just not used to that. They're just used to money going in their bank account. And they spend money and that's all that they care about. Like you said, they just want to go do what they do.

Annie: Well, they're also used to just taking distributions and thinking, oh, well, you know, I made enough money. I need to take some money out, you know, for myself. And now once you get into these entities, now you're looking at having a salary. So that's another shift mindset. You can't just pull money [00:11:30] out as a distribution. You need to take a reasonable salary.

Jeff: And and that's the most important thing I think.

Annie: It's a hard discussion.

Jeff: What's a reasonable salary. That's probably the meat of it, because you're going to get things that are all over the place when people come in. And if they come to me and they're an S corporation already, I see crazy things. But the reasonable salary conversation is an important one to have.

Annie: How does that go for you?

Jeff: Well, so first you start with what they do for a living, because a person that owns, say, an [00:12:00] engineering firm with ten employees might have a different salary than, say, somebody that owns an auto body shop with ten employees. Right? So there are publications to where you can find out what reasonable salary really means, but it's not the only determining factor. You also have to look at profitability. And that's kind of where I start because let's say for example, you have an engineering firm and you think that their reasonable salary should be $100,000. Well, if they're only making $50,000 in profit, you can't do $100,000 salary. That's the [00:12:30] worst case scenario is to pay yourself into a loss, because then our clients are paying FICA Medicare on money they don't have and they didn't earn. And so that could be the worst case scenario. And I see that all the time, by the way, people come into my office with an S corporation already set up, and for years they've been paying themselves into a loss. And I'm just like, what is that's they might as well just be an LLC and pay the self-employment tax on everything they make at that point, because now they're overpaying FICA Medicare for no reason whatsoever other than they're not getting the advice they need from us.

Roger: What do you do? I mean, [00:13:00] because everybody hates paying into Social Security until they're ready to draw it, then they're all complaining because their benefits aren't what they thought they would be. How do you find that when you have that discussion with someone that you know, everybody thinks about today, they don't think about the future. So I want to pay the least amount of Social Security I can. But do you tell them what could happen? Just not not that they're going to change because they're still going to make a decision based on today, but do you at [00:13:30] least make them aware that understand that paying not paying into Social Security when you're ready to draw Social Security could have an impact?

Jeff: I do, and some of my clients, like you said, when they're older. I had a client in here the other day that said that exact same thing. Well, I realize I'm over paying myself salary, but I need to pump up my Social Security benefits. That's a fine attitude to have. First and foremost. I think our job overall is to protect our clients from audit risk and to save them the most. Tax dollars [00:14:00] is today as possible. So depending on their age, you know, I don't particularly I don't think it's a great bet to decide to send the IRS more money, hoping to get it back later. That seems like a bad bet to me. I would prefer them to save the tax dollars today and put the money if they can. If we can save them and they're a little bit older, $7,000 in payroll taxes, that's 7000 they can fund their IRA with, which is a much better investment, in my opinion, than sending it to the IRS, hoping to get it back. So even even [00:14:30] with that. Consideration. I generally say our goal is to save you as much tax dollars as possible, and if we need to save additional for your retirement, that should be a part of our overall plan. I think that that's a better way to look at it. No, I agree.

Roger: With you that the important part is what you just added. Put that money into another retirement plan that will produce probably better benefits, because I've heard this from my entire career that if you had to sell Social Security as a product, very few people would buy it, because [00:15:00] the amount that you put in with no guarantee, you know, your family can't inherit it. You know, it's basically if you die, it goes away, the return, the restrictions. You're much better off taking that money to the extent that you can justify a lower salary, take the additional money, fund the retirement account. And if you do that in your business, don't you? Isn't that part of your service to clients? Don't you have kind of a financial planning. So it kind of fits for you to do that?

Jeff: Absolutely. I mean, that's a part of our job is to look at [00:15:30] the overall tax picture, including their retirement package and what they're doing in salary, and then adjust it based on their goals, because there's all kinds of different opportunities based on their needs and wants and their age. I mean, you can get very carried away if you're the only owner. You could do a 401 K with a profit sharing plan where you can dump 50, $60,000 what the maximum is anyway, into these retirement packages every year. It's an enormous amount of money if that's your goal. So we have to align their goals with their cash flow. [00:16:00] It absolutely. That's a part of what we should be doing as their advisors.

Annie: And sometimes they don't even realize that they're doing something inappropriate or wrong, so to say. I mean, it's hard for them, the concept of distributions versus reasonable salary and what is reasonable. And like you said, it does matter on characteristics. I mean, it could be, you know, how long you've been in the business, your background, your education, profits, employees, you know, that kind of stuff. So [00:16:30] it's I imagine that you probably have this conversation over and over again. And sometimes it, you know, they're in full agreement and sometimes you probably get some pushback.

Jeff: Well, you get the pushback when the bills come due, right?

Annie: Right, right, right.

Jeff: That's that's when the pushback comes. Okay. You need to fund this. And they want $50,000 from you. Oh well right. Don't have that. Yeah. So it's just a it's a planning function. And I think that's all a part of our job. I don't particularly do financial planning meaning invest in this mutual fund [00:17:00] with this money. I don't do that part of it because it just doesn't interest me. But I definitely look at it from a tax perspective and say, this is another tool in your bag that you can use to save tax dollars and put away for your retirement. Yeah.

Roger: And this whole.

Annie: Do you ever get like why, why, why an S corp? Why not a partnership or C corp or my friend at dinner the other night said that partnership is the best way to go. You know, you hear those kinds of conversations.

Jeff: I think this is where when people come to me with, [00:17:30] I've been doing this for years and I don't even really know why I'm doing it. That's a that's a real downfall in our industry. People should explain to people why we're doing what we're doing, why it to be an S corporation instead of, say, a C corporation, why be an S corp instead of a partnership? And it comes down to tax savings and it comes down to a lot of different things. And I think it's our job to educate why we're doing what we're doing, not just say, do it this way, because most of the people that come across my desk are saying, well, they just told me to do it that [00:18:00] way. I've just been doing it that way forever, and they don't know why. And that's not a good that's not a good, that's not good for us and it's not good for our clients. I think that sometimes accountants like to be up on a pedestal a little bit and say, well, I'm all knowing and seeing and you just do what I tell you to do and I'll save you some tax dollars. That's a horrible relationship. I think the more we explain, some might say, well, the more you explain, then the less useful you are, because you've told them exactly why you're thinking what you're thinking. And I think it's the exact opposite. I think it makes us more useful [00:18:30] to explain all of this to our clients, to the best of our ability. So until they fully understand what we're doing and why, sometimes it takes a quarter or two to get through it and they go, I don't understand the salary. And, you know, I need more money out of my business. I can't live on $24,000 a year. I understand, and we'll talk about that. And there's different ways to take money out of your company than salary. So it's just educating the client, I think. And there's a huge lack of education in our industry. Yeah.

Roger: And you make a great point about talking [00:19:00] to your clients because, you know, someone may come to you and say, well, I'm a C corp because I was told I would pay less in taxes because the corporate tax rates are less than the individual tax rates. And that might be true in the short term, if that's all you're worried about is your taxes today. But I think to your point, we're obligated to talk about what happens ten, 15 years from now when you're selling this business and now you're a C corp versus an S corp. And the disadvantages or advantages of both. So I think you make a great point Jeff, that if [00:19:30] we just. First of all, we need to talk to the client. They may. Maybe they're short term oriented. They're not long term oriented. They don't care. About 20 years from now, they'll deal with that, you know, in 20 years. But they deserve that discussion.

Jeff: Absolutely. And you're right, there might be extenuating circumstances where I would change my mind. But for the most part, s corporations are right for the vast majority of business owners that have some decent profit.

Roger: And particularly you're going to.

Jeff: In my opinion, you're going.

Roger: To particularly appreciate that when that hopefully time comes down the road when you are [00:20:00] selling your business and you're not faced with those double taxations and you talk about kind of the rules that catch you when you incorporate or put an entity around you, they're a lot tougher if you're a C Corp. I mean, maybe talk about that. The S Corp gives us a little more flexibility for that person to still be who they were before they changed their entity, where they thought everything belonged to them. The money belonged to them, the inventory belonged to them. Everything in the business belongs to them. But it doesn't. It really belongs to the corporation. [00:20:30] Talk about how the S Corp allows some flexibility on normal small business behavior.

Jeff: Well, yeah. So like we all know of of clients that go out and they put things on their, you know, personal or on their business credit card that shouldn't be on there. You know, they went and did whatever played, went on a vacation, a Disney vacation with their family. And it has nothing to do with business. They're not doing anything for business. They're not meeting any other accountants on the boat. Well, [00:21:00] you can just call that a draw in an S corporation. C corporations don't have anything called distributions or draws. They just simply don't. You have to take 100% of what you take out of that company in salary or in a double tax dividend, so one or the other and both are not good. Right. Because in the first scenario you're basically now just an LLC anyway because you're paying self-employment tax on 100% of your earnings. And secondly, there's zero flexibility to your point. Roger that. You just you can't ever [00:21:30] use your business card or take distributions without without it being a consequence of a of a dividend. Basically that then is double taxed, taxed at the C Corp level and on your individual level. So it's it's bad all the way around. Not when you sell it certainly is worse but it's also worse just year by year paying self-employment taxes on all you make. That's you know, when you're talking about somebody making $100,000 a year and in an S corporation, let's say we can justify $50,000 a year in salary or half that saves them $7,500 every [00:22:00] year, year after year after year in payroll taxes. That's not a small amount of money. And, you know, to a small business owner, that's an enormous amount of money.

Jeff: And then maybe it grows. And now they're at 200,000 in profit and 300,000 in profit. And we really can, you know, the salary will have to go up to like a max level. That's what I like to talk to my clients about. So I have kind of a generalized rule that doesn't take into account whether they're an engineer or an auto body shop owner. It's more just a generalized rule [00:22:30] of roughly 50% of your profits should be in salary. This is my rule. It's not an IRS rule or anything. It's just kind of a guideline that we can use. So if you have a client with $60,000 in profit, maybe we want to do a $30,000 salary. This still saves them $4,500 in self-employment taxes, which more than covers the 2 to $2500 it costs to be one. So it's worth doing at that point, you know, but let's say their reasonable salary again, it's let's say it's an engineer and their reasonable salary should be [00:23:00] 100,000. They can't do that. So we just have to come up with something reasonable comparatively to their profit, until they reach that time to where, say they're at 200,000 in profit, then 100,000 does make sense. But then if they hit, say, 300,000 in profit, we don't have to continue to raise that to 50%. In my opinion, we could probably keep the salary at $100,000, saving them FICA, Medicare for the next 40, and then Medicare for all the way up to the $300,000 mark. So it's still significant savings even at a higher salary [00:23:30] level, like $100,000 a year when they're making 2 or 300,000.

Roger: And the IRS has said for years that this reasonable salary is a priority for their auditors, because, again, while you're trying to save them that money, the IRS wants to earn that money or protect that money.

Jeff: Exactly.

Roger: Have you ever had it questioned? Have you ever had an audit where reasonable compensation was actually an issue?

Jeff: I have. I had a client just last year that was audited on this. He'd been doing. It's [00:24:00] the type of client I only see once a year, and he had been doing a $10,000 a year salary forever since I'd known him. And every once in a while he'd have a good year. And I'd say, you know, 10,000 isn't nearly enough. We need to do something about this. The next year he'd come back same 10,000. He finally got audited on it, so he made about 100,000 in profit and took ten inches salary and 90 in dividends. Distributions, distributions. The auditor came in. So now our job is unusual. I had to convince the client ahead of time. We have to make [00:24:30] you sound as useless as possible in your business, which is a really funny thing to do. So yeah, it's he plays with his kids all day. He's taking them to school, picking them up from school. He just doesn't have the time to work. And this was the task we were on set with. He was a construction guy, so he's doing remodels of basements and kitchens and things like that. So we argued that he basically hires contractors to swing the hammers, and he doesn't do any of it, and he just pops in checks on them, makes sure they're doing their job properly, make sure the job is going the direction it wants to be. And then he leaves and goes and plays with his [00:25:00] kids.

Jeff: We were kind of successful. So the auditor determined that 27,500 was a fair salary for a two year period of time. So a couple of things. One is he got away with $10,000 for over a decade when he probably shouldn't have. So he saved a ton of money. So this cost him $5,500 plus some interest. They didn't even charge penalties. It really wasn't that bad of an outcome. And now we also have a stamp from the IRS that says 27 five is a reasonable salary [00:25:30] for him. So I don't know how they could argue different the following year. So we've now set his salary at 27 five for this year. And we'll see. He's now hiring me on an ongoing basis to kind of monitor it. Nice profit. And so we're going to do a little better job for him. If his profits continue to increase we're going to increase the payroll. But but we've got a good starting point. And and the audit was interesting because they didn't ask about distributions or they didn't ask about much of anything. They were very concerned. [00:26:00] How many hours does he spend a day doing this? Interesting. What's his expertise level? These were the kinds of questions we were being asked. It was not how much did you take in distributions, which I was relatively surprised by for me.

Annie: Too, because I've seen I've seen where they well, I've seen where there's been nice sized distributions when there's been no salary. And that sort of like a goose egg, just, you know, hanging out there waiting for somebody to identify. But I haven't seen your particular situation where they just, you know, were [00:26:30] looking at the how was it a little too low. Was it a little too high kind of thing, you know, having a lot of distributions, significant distributions with no salary to me is a red flag. So I'm not surprised we see that more often.

Jeff: Well, and I think, you know they did a study this is probably 15 to 18 years ago on S Corporation. So these numbers are wildly outdated. But it always stuck in my head that the average S Corp profit was somewhere around $320,000, and the average salary was 8000. So [00:27:00] what that tells you is there's tons and tons and tons of people out there that are paying themselves no salary at all to bring that average way, way down. And that is just a huge red flag in my opinion. Yeah. You know, if I get somebody that's an S corporation that comes to me in February and needs their work done and they've taken no salary, I will do a workaround on that. So let's say we determine that 30,000 should have been their reasonable salary, that they should have taken.

Annie: The previous year, even though the year's over. Yeah.

Jeff: Yeah. We'll issue a 1099, which is [00:27:30] now typically late because it's due in January. But we'll do it anyway. And then we'll just put that on a schedule C with no expenses. At least then he's paying the self-employment tax that's required to be paid. It's not perfect. It's not a great answer, but it's a workaround. If it then the following year, you have to correct what the client's doing and you've got to get them on payroll and you've got to do it the right way.

Annie: It shows the quick fix. Well, it shows that you are aware and you know what should have happened. And you're doing your best efforts to remedy that. So and I think if you can good faith effort.

Jeff: And [00:28:00] if you can convince them to do payroll the following year. Oh, absolutely. I think you'll be I think you've fixed the problem. Yeah, that's an interesting problem.

Roger: I actually had a discussion with the IRS about that. Where a problem comes to you and you're trying to make it better, you can't make it perfect. And how does the IRS look at us as the preparer in those situations? We're making it better. But we didn't make it perfect because technically, I guess you could say, you know, if you want to follow the [00:28:30] rule book, which doesn't work in the real world. Yes, you could have refused to do that tax return or insisted they amend all the 941 seconds. The client would have just gone to someone else and probably done nothing. So I asked them. I said, given that situation, how do you look at us as the practitioner in those problems? And it kind of caught them off guard because they want to stick to the rules, but they realize that. Sticking to the rules actually makes the situation worse, because you and I both know there's [00:29:00] somebody they could have taken that tax return to Jeff, who wouldn't have even thought about what you did, much less amend the payroll returns. They'd have just let it go and probably gotten away with it. So they told us, we look at your making the situation better or worse. So hopefully that will be there. That's good long term strategy because you did make it better and you did make it better, particularly going forward. Because again, we are we are in an industry where some people aren't as ethical as you are [00:29:30] and trying to make it better, and the business owners are finding those people.

Jeff: Yeah. You just you have to look. The outcome is the same. That's what I always think the IRS, you know, at least I would hope they would do is look at this and go, we got our 15.3% on some of their revenue. That's the intent. That's a reasonable salary. Let's just move on. That's what you would hope would happen as long as again, as long as you've gotten it better. And then the following years they follow the rules to the letter and they do what they're [00:30:00] supposed to do. But it's better than. So I'm glad the IRS at least somewhat admitted that.

Roger: I mean, again, the rules, they could they could get technical and say, yeah, but you didn't deposit on time. You didn't do all these things that had you been salaried, you know, they can make and this is always and again, I'm kind of opinionating here not stating fact. That's where it's always better to have an experienced auditor than a brand new one who all they know is what they learned in class or in the book.

Jeff: Yeah.

Roger: Because the book tells you to do it one way. [00:30:30] But that experienced auditor understands what's happening in the real world. And yeah, it's. You hope to your point that they look at what we're trying to do. We've made it better. We've made brought them into compliance. Yeah, maybe we should have made deposits. But you got all the big money, you know, that you're entitled to. So let's move on. But I love your story about having to make your client look useless and ignorant and not worth.

Jeff: You know, that's a good one.

Annie: I'll remember that one, too.

Jeff: You're [00:31:00] this. You're as useless to your business as you possibly can be.

Roger: I don't know why anybody would hire you, but hey, they do. So there you go.

Jeff: Yeah.

Annie: So let's talk logistically. So you just they come in, they agree. Okay. Let's do let's be an S corp. And obviously there's something in S Corp election that is made and and there's rules on when it has to be made and how to make it. So do you. You guide them through that and you prepare that election for [00:31:30] them.

Jeff: So we typically do. So there's you know obviously they first have to go to the secretary of state and then they have to get an Ein number. Those two pieces are fairly easy. And so a lot of times and recommend you go ahead and do those and save yourself the money. Having to pay me to do that. Okay. If they're just the type of, you know, we have all different kinds of clients. Some people are so terrified of anything that has to do with the government, they want to do all of it. That's just fine. We'll do that too. But then the steps that I do recommend, like if they're an LLC, [00:32:00] they have to file two forms. They have to file the 8832 form, an entity that basically says, well, I'm an LLC, I'd prefer to be treated as a corporation. And then they have the 2553 form that says, now that I'm a corporation, I prefer to be the S corporation. So it's those two forms. Those two forms are fairly easy to do. But again, I recommend that they let us do those. Okay. If they. Absolutely. If they're the type of person that's relatively bright and can do this on their own, I'll allow them to. But usually they end up coming. You don't.

Annie: Want to mark the wrong box [00:32:30] and then have to go.

Jeff: Back.

Jeff: Right. And then there's you know, the IRS always accepts late filing exceptions. I've never seen one turn down in 23 years. But you have to know how to do that. And there are certain things you have to put at the top of the form. And it's just there's it's not that difficult if you read the directions on the IRS website, but still it's not something that the client can does all the time, typically properly do. And then in Colorado, we do have to get a withholding license and an unemployment license, okay, as most states do. And I help them get those [00:33:00] as well. Okay. So typically we charge 200 bucks a piece per form and people don't complain about paying that.

Annie: Yeah, I don't think that's too high for for just having it done right. Underpriced because having you know, when when there's an error fixing it is actually more difficult, in my opinion, than making the election and switching to the S Corp, you know, having to go back and correct an error and wait for a notice and update this and update that. I mean, that's when it really [00:33:30] gets time consuming.

Jeff: One of our clients, just recently, one of my employees was telling me that that they asked, did your attorney do these documents? And the taxpayer said, no. Our client said no. Well, it turns out they had. So now we had to S Corp's we had to iron numbers.

Annie: See that's what I'm talking about.

Jeff: And it was a it's a real nightmare to unwind and you know so it's costing her more money now to unwind this than it would be if she would have just double checked. And that's my point. Made sure it was all [00:34:00] done by one of us. So you do have to make sure the client's coordinating with the the attorney, because sometimes the attorneys will just do the secretary of state and the iron and leave it at that. Oh, but some others do all of it. So you just you have to be aware of that.

Roger: Now.

Jeff: I'm sure that makes sense.

Roger: About not handling the set up properly. I'm sure in your life you've had someone come to you that's been filing an S Corp return for a number of years, and then they get a letter that says, we have no knowledge of you being an S Corp. We never [00:34:30] got the election. Fortunately, there's ways to handle that too. I'm sure you've handled that for clients.

Jeff: Yeah. You know frankly again you can do the late filing of the S Corp back to the date that this letter came from. And the weird part about it is the IRS is all over the place with this. Like, I've had clients that told me they were an S Corp will file S Corp paperwork for five years before they get that letter. It's so odd. It just you don't know when that thing's coming. And if the if the client can't produce the original paperwork or if we didn't do it, then [00:35:00] we just redo it, and it's usually accepted, and we can all reasonable cause.

Jeff: Yeah, yeah you can.

Jeff: I usually put miscommunication between accountant and client. That's usually what I put. And it works most of the time. I mean you can get more creative than that, I suppose. I don't think whatever works.

Roger: I mean, as long as it works. And that's been a change. I'm older than probably the two of you combined on this call, but there used to come a time that if you missed an S Corp deadline, it was over. There was no leniency, [00:35:30] no nothing. And it was a complete nightmare. I think, again, understanding how the real world works. The IRS finally decided we've got to be a little more lenient here. So to your point, Jeff, I think now they almost accept anything if you just follow the process.

Jeff: Yeah, that's been my that's been my experience so far. The IRS gets it wrong sometimes and the court paperwork was filed and they're still getting that letter. That happens too.

Jeff: Good point.

Roger: You mentioned something as we talked earlier [00:36:00] that we want to make sure that people are aware of a great trick by being an s-corp. If this relates to salary and being an s-corp. What if somebody has a huge change in their tax situation in October or November, and they haven't made estimated tax payments? Talk about what you can do in an s-corp to help eliminate that underpayment of estimated tax penalty. And you can do it in a C corp. This can be done in any corporate. But we're talking primarily [00:36:30] here about S Corp.

Jeff: Well that's the great benefit of doing your your tax estimated payments through the payroll. And I'm a huge believer in that. And I actually I suggest our clients do that. And the reason is is because it's flexible. They consider those payments ratable through the entire year. They don't say, well, this one has to be done by April 15th, in June, and so on and so on. It's always just what does the W-2 read at the end of the year, so we can force the W-2 at any given time to read what we want it to read, as long as we're still in December, [00:37:00] basically December 31st, you could run a $40,000 payroll with $20,000 in federal and $8,000 of state taxes withheld. You can do that common if you need to, you know.

Annie: Year end bonuses. I mean, you see that happen a lot. You know, people will give themselves a bonus when they're really just shoving it into federal withholdings to, to cover the income throughout the year.

Jeff: But I don't even know if the IRS if the left hand is talking to the right hand on that one. I don't think they're looking at the 941 seconds determining when these salaries were done. They're simply looking at your tax [00:37:30] returns with a W-2 attached. Right, right.

Jeff: That's exactly yeah.

Roger: They've said it's a W-2. It is deemed to have been paid equally throughout the year. Even if it wasn't. So it gives you a great flexibility at the end of the year which kind of goes which may go against your rule about how much salary to take, because you may have a reason to take some at the end of the year to avoid a bigger penalty at the expense of paying some social Security that you otherwise wouldn't have advised them to do, if that makes.

Jeff: Well, and if.

Roger: That [00:38:00] makes any sense, the.

Jeff: Way I just this.

Annie: Only this only works if you're in conversations and communications with your clients throughout the year. This you know, the clients that come in in April, you know it's too late then. So yeah.

Jeff: Definitely you can't.

Jeff: Unless you're part.

Jeff: Of the 1099. You can't.

Annie: Yeah. No, I mean, it's that's the importance of having relationships and having quarterly or monthly conversations. So things like that can be addressed before your end.

Jeff: So I developed [00:38:30] something for people that are owners only. So they have no employees. It's just them. They're the only employee of their S corporation where every quarter they'll usually the first quarter we do just some something to put a marker in the stand of one fourth of what they did last year. But then in quarters two, three and four, they'll discuss their profit and loss statements with me. If I'm not, if I'm not preparing them for them because we're talking about somebody's small, like a consultant or something like that, where they just have very few expenses and they don't really need monthly bookwork. [00:39:00] They just need the payroll help, the tax help and the advice. So I developed this to where every quarter, it's not a way that the the, the owner takes out any income at all. It's simply we're doing the two things that are most important with salary. The two most important things are showing the IRS that we're taking a reasonable salary, and it's a great way to pay an estimated taxes. Frankly, those are the only two reasons an owner needs to take payroll to begin with. So I've just cut to the chase and combine those two things into a quarterly advice system to where we say, okay, well, let's increase your payroll, you're [00:39:30] doing better, or let's decrease it or whatever the case may be, or I had a terrible quarter.

Jeff: I'm more seasonal. I can't do a payroll this quarter, but next quarter I can double it because this is my busy season, right? You know, all these different kinds of things we can play around with and really get them where they need to be. It's inexpensive for them because they're not paying for the monthly book work. They're just paying a quarterly fee. Yeah, roughly $300 a quarter. And that gets a little bit of my time to kind of do a tax projection, which they're paying me for the tax returns as well. [00:40:00] So it's I kind of need to do those tax projections anyway. But this is a way for me to build that into the payroll system to where we also do the payroll for them. But it's an advice, and it's a way to make sure that December payroll and the W-2 looks exactly as we want it to. That's the key, in my opinion, is what do we want it to show? And it should look exactly like that and we can help them do that.

Annie: I love it, and it's an opportunity to chat with the client on a quarterly basis. There could be something going on in the business that they don't even realize has a tax ramification. [00:40:30] And then you have the opportunity to kind of, you know, talk to them about other things, not just payroll. And, you know, it's kind of like a. Mid-year, check in on a quarterly.

Jeff: Basis, and things.

Roger: That happen outside the business that we don't know about. You know, they could have had a huge that's true. Sale of land or stock or something that dramatically changed their tax position, that if we just see them once a year, by the time they come.

Jeff: To us that.

Roger: You know, that ship sailed, I mean, they're.

Jeff: Well, the opposite could be true. What if they bought some new equipment and now [00:41:00] their profitability is going to be down to 10 or 15,000? Good point. They're doing a $50,000 salary.

Jeff: No, it's a good point. The more you can meet.

Roger: And you mentioned two critical points meeting with clients on a regular basis. And secondly, getting paid for those meetings.

Jeff: Yeah, absolutely.

Roger: It's a win.

Jeff: Win, not free.

Roger: Meetings by the way, because that's you know, you're helping them and and there's value to it. And you should be compensated for that value.

Jeff: I have just structured into a formalized system. That's that's all I've done [00:41:30] with that is I'm doing the same thing everyone else does and consulting with these clients on a quarterly basis. I just have it structured to where my employees send out the reminder emails, hey, we're going to run the same as we did last year. This is a great time to talk to Jeff about your tax situation. And I just think it's a the people that I have on it, which I have over 110 on it, I think now is they just love it. They just think that it's a, it's it's a great service.

Jeff: Well yeah, I like it and I.

Roger: Keep going back. I'm selfish here in terms of you getting paid for that. But in either case they [00:42:00] bought the heavy equipment and their income went down or they sold some land. Their income went up. By structuring it, you're getting compensated for that discussion as opposed to them just picking up the phone in July and saying, hey, I sold some land. What do I need to do? Which we're all guilty of giving that away for free. So you've turned a lot of free advice into advice that you get paid for, which is not something we should apologize for. It's why we're in business.

Jeff: Absolutely.

Annie: And maybe they won't call you five times during the quarter [00:42:30] and they'll just save it all, all their questions for that one meeting.

Jeff: So they know you're going to meet, could also.

Annie: See the benefit of giving some time back to yourself.

Roger: Before we wrap up one other issue, we talked a little bit about the difference in C and S corpse talk, just a little bit about the advantage of an S corporation when it comes time to sell the business. Why? Why being a C Corp is I mean excuse me, an S Corp is is historically and normally better than the C Corp.

Jeff: Kind of that long.

Roger: Range discussion that some people [00:43:00] may or may not want an.

Annie: Exit strategy.

Jeff: Yeah.

Jeff: Well, really what it is, is about double taxation. Like what it is for everything with a C corporation, because most of these companies, what they do is asset sale, not stock sale anyway, which is typically what I recommend. I don't know what attorneys recommend. They seem to be all over the place with this, but usually from an accounting tax perspective, it's best to sell assets. It's more protection for the old owner and the new owner. It's just it's smarter to do an asset sale and then start a whole new company. And when you do that, you pay the capital gains [00:43:30] tax just once on an S corporation, but twice on a C corporation. Well, it's not capital gains the second time, but still.

Jeff: And it's just still not good. It's more.

Annie: Complicated.

Jeff: Yeah. It's more complicated and it's just not as good. I think that the best way to do it is, is through an S corporation as an asset sale. The only time I recommend C Corp's anymore is if they're buying a business through their IRA, through the retirement, and then.

Annie: You have to be.

Jeff: Then you have to. But other than that, it's not a good idea.

Jeff: And that may or.

Roger: May not be a good idea depending on your situation. But you're right. [00:44:00] If that's the only way you can acquire a firm or a business, then you have to be a C corp. You don't have the luxury of saying, well, I'd rather be something else. So I mean, any kind of final thoughts? Jeff, on on you've been first of all, thank you so much for taking time and doing.

Jeff: I know this is great.

Roger: It's been great and I hope that our audience has learned something and I'm sure they have. But you've offered a lot of advice. Again, you're talking to practitioners. Is there any anything you'd want to tell them as we kind of [00:44:30] wrap up here to, to think about or anything.

Jeff: I just I think the key when you're dealing with an S corporation in the salaries and all that is to be intentional. It's not just let it be what it's going to be, not just set it at whatever you set it at the year before and leave it that way for decades and decades. This is that's not the right way to do it. The whole point of the S Corporation is to maximize the FICA Medicare tax savings while remaining compliant and getting as much benefit as you possibly can out of it, and and [00:45:00] doing a cost benefit analysis for the client. Right. And being honest about it. Look, I'll make more money if you're an S corporation, but it's not best for you at $20,000 in profit. That's a fine thing to say. And it's the right thing to say because that business will get over 50, 60,000 in profit. It will grow. And now you've built in trust, which is the most important thing we can build in.

Annie: So when the time is right, the times will be right. Yeah.

Jeff: I think you just look at it as a holistic perspective, the cost analysis, what you're doing, what their future plans are, all these different things. You need [00:45:30] to listen to the client first. Develop a plan that where this S corp is going to be utilized in the best way possible, with the most tax savings while remaining compliant. And that's it. I think just always put the client first when it comes to this. If you do that, you're going to win every time.

Roger: And there's nothing wrong with taking advantage of the tax code when it helps our clients. I think sometimes we all people are nervous that, well, if that saves me money, doesn't that mean I'm going to get an audit? Well, maybe you do, but if it's the right thing to do and you're following the rules, [00:46:00] who cares? You know why pay extra money just to maybe still get an audit, but to feel better about it? So we should always use the tax code when we can to lower taxes and not just be afraid of it because it's not maybe common sense or just lays out there. We have to. It helps to be smart and know the rules.

Jeff: Mhm.

Jeff: Absolutely.

Jeff: Yeah.

Jeff: And keep your client first and foremost in mind. I think that I just, I can't be a believer [00:46:30] in that enough. My, my mindset switched probably 18 years ago where originally I was like I'll do anything. I just need to get some clients in the door paying me money. I'll tell them whatever they want to hear and I'll help them do whatever. And it just it changed once and I just said, you know what? I'm not going to worry about me and my pocketbook at all on this. I'm going to do what's right for the client charge a fair price, of course. Right. And as things more get, get more complicated, I make more money. But put them first. And if you do that, you're never going to lose because they're going to trust you forever. Rightfully so. And you've got [00:47:00] their best intentions at heart. And this is just one another way we can help our clients get to that goal.

Roger: And one of many.

Jeff: Ways I love it.

Roger: Any any final.

Jeff: Thoughts?

Annie: No. This was so fun. I like having guests on here. Thank you so much, Jeff.

Jeff: Thanks for having me. This has been great.

Annie: Good topic, good information, good stories. I hope the listeners enjoyed it. If you're out there like us, tell your friends about us, follow us, and we certainly will be coming back with some federal tax updates. And then I think we're [00:47:30] going to have a couple of other guests join us in the before the end of the year.

Jeff: So, yeah, and if you're a.

Roger: Small business owner in Littleton, Colorado, and need a really good person to help you go find Jeff. Jeff, you want to you want to tell us about your website and your phone number if somebody out there wants to reach you.

Jeff: My number is [phone]. And my email is Jeff at padget. Littleton.com. Very easy.

Jeff: If any of you.

Roger: Out there need Jeff's help, or if you have a client that needs Jeff help. And [00:48:00] I guess I was going to say in the Colorado area, but gosh, today we can have clients anywhere, I mean anywhere. We're doing this podcast and we're in three different places. So, I mean, we can we can do a lot of things. Jeff, thank you so much. I know this as we're recording this, a deadline has just ended. So I'm sure you're a little tired and ready to probably take some time off.

Jeff: And I might I might take some time off.

Roger: I hope you do. For you. You've earned it. And again, thank you so much [00:48:30] for doing this, Annie. As always, thank you for being part of our podcast. And to the listeners, thanks for for continuing to listen to the Federal Tax Update podcast. I hope that you'll if you're enjoying this, you'll you'll pass this on to some of your colleagues and let them listen in as well. And we'll be back. I'm not sure if it'll just be me and Annie next time, but we'll be back soon with another federal tax update podcast. And thanks for listening and we'll talk to you again soon.

Annie: Bye, [00:49:00] everyone.

Jeff: Bye, everyone.